Tuesday, December 29, 2015

Making forecasts is foolish, but it is my belief that one must have a view on both the economy and on what the market expects of the economy in order to invest with confidence. For example, taking on risk when the market is risk averse is potentially more rewarding than taking on risks when the market demands a high price for it. So that readers may judge how successful (or unsuccessful) I've been in this regard, it has been my custom for a number of years to annually review the success or failure of prior predictions while at the same time offering up predictions for the future.

Mostly right: I thought the economy would improve somewhat on the margin, even though the recovery would remain sub-par. The economy didn't pick up much if at all, unfortunately. However, confidence is beginning to return as investors weigh the prospects for significant growth-oriented fiscal policy reform in coming years and as energy prices plumb new lows.

Wrong: I worried that the Fed would be slow to tighten, and that inflation would consequently exceed expectations. I've been wrong on this score since 2009, since inflation remains firmly in check. I consider this a fortunate mistake.

Mixed bag: I thought sharply lower oil prices would liberate a lot of economic activity, boosting growth prospects. While there's some evidence that cheaper energy has been a positive (rising consumer confidence, increased vehicle miles travelled, higher real yields), the energy-producing sector of the economy has suffered significantly, and the shock has had a dampening effect on the larger economy. In short, I underestimated the extent to which oil prices would fall and how damaging the shock of lower oil prices would be to energy-producing sectors.

Mostly right: I thought cash would be an unattractive investment relative to just about everything else, with the notable exceptions of commodities and gold. Equities have managed to generate a modestly positive total return for the year, but corporate bonds have suffered sizable losses, particularly in the high-yield energy sector. Commodities and gold have turned in yet another miserable year, but real estate has done very well, particularly of the commercial variety.

Right: I thought a recession was quite unlikely, and the danger of deflation was exaggerated. Although growth has been far from impressive, the economy has nevertheless managed to grow by at least 2% this year with no signs of emerging weakness. Although headline measures of inflation have been hugging zero, core inflation has been running a solid 1.5-2% for many years and continues to do so.

Mostly right: I thought profits growth would continue to slow, and gains in equities would come mainly from an expansion of multiples. As it turns out, corporate profits actually declined a bit, but PE ratios have risen, and have accounted for the bulk of this year's net gains.

Right: I thought the dollar would continue to strengthen, since the U.S. economy was likely to exceed relatively dismal expectations. As of today, the dollar is up almost 10% against other major currencies.

Here's what I see in my crystal ball for 2016:

I remain generally optimistic, mainly because I think the market is still dominated by risk aversion and caution (e.g., corporate profits relative to GDP are significantly above average, but PE ratios are only marginally above average, and interest rates are still historically low). But it's an optimism tempered with caution. I think the economy can do better than expectations (which are quite modest) even though growth is likely to be disappointingly slow from a longer-term historical perspective, much as it has been for the past six years. I like the fact that the economy still has a considerable amount of untapped potential which could be unleashed with a shift to more growth-oriented fiscal policies. I'm also comforted by the fact that financial markets are highly liquid, systemic risk appears to be very low, and the yield curve is positively sloped (i.e., swap spreads are very low and monetary policy is accommodative). In short, the market is still rather cautious, and expectations for the future are not very optimistic, and that's a low bar to clear.

I know that many argue that risk assets are wildly over-priced because of easy money, but I'm not a buyer of that view. Interest rates are low and inflation is low—despite an abundance of money—because the demand for money and money equivalents is still very strong. The Fed has not artificially depressed interest rates, it has instead responded to very strong money demand by increasing the supply of money. The only way to understand why inflation remains low when cash yields almost zero and equities have an earnings yield of more than 5% is to realize that the market deeply distrusts the ability of corporate profits to sustain current levels.

The Fed is finally in "tightening" mode, but is unlikely to move aggressively, at least for the near term, and that is fully priced into the term structure of yields. Nevertheless, the key variable to watch is confidence. Since 2008, confidence has been lacking and the demand for money has consequently been very strong. The Fed was right to engage in QE, because if they hadn't supplied all the money the market demanded, then we would have had deflation and perhaps another recession. But if and when confidence returns with a vengeance, then the demand for money and money equivalents (of which there is a virtual mountain) could decline faster than the Fed's willingness and ability to offset this by raising short-term interest rates. In short, a substantial improvement in the economic outlook could result in the Fed raising rates too little, too late. And that, of course, would result in a significant oversupply of money, which in turn could fuel an unexpected rise in inflation and higher bond yields. I've been wrong on this score for years, but that is no reason to discount the risk of this happening over the next several years.

I also worry that neither of the current frontrunners—Trump and Clinton—have a good understanding of what ails the economy (e.g., too much government spending, burdensome regulations, high marginal tax rates, particularly on corporate profits, and an impossibly complex tax code). The policies Clinton is advocating would only exacerbate the problems that already exist (more subsidies, higher marginal tax rates, more spending, more regulations). At the same time, too many of the policies that Trump advocates are populist in nature (protectionist, xenophobic, authoritarian) and therefore anti-growth. There's still plenty of time for policy advocacy to change for the better, but until the debate focuses on more pro-growth policies, I doubt that the economy will do much better than 2-3% growth.

In short, I see more of the same slow progress as we saw this year, but with substantial upside potential lurking in the background. For the time being, this puts a premium on investments that offer more attractive yields than cash (e.g., dividend-paying equities, corporate bonds, and commercial real estate), and it spells more trouble for gold and commodities. I think the odds favor a somewhat stronger dollar, for the same reason as they favor equity investments relative to cash; the U.S. economy still has the potential to surprise on the upside, and there are no immediate reasons to expect economic conditions to deteriorate.

Given the thrashing that emerging markets have endured for the past few years—thanks to a stronger dollar, a better-than-expected U.S. economy, falling commodity prices, and the inevitable unravelling of leftist and statist policies in many of these economies (e.g., Brazil, Argentina, Venezuela, Chile), the coming year is likely to see the beginnings of a long-awaited and much-needed recovery. I note the recent, impressive victory of Macri in Argentina and his rapid implementation of strong, pro-business and pro-growth policies. Argentina looks to be the bellwether for the region, leading the way for similar reforms in Brazil, Venezuela, and Mexico, and even in the U.S. It's not too much to hope for, and it's about time.

43 comments:

The recent omnibus spending bill that Ryan just passed suggests to me that the probability of needed fiscal reforms may be diminishing.US stocks are extremely cheap vs the history of earnings and interest rates for good reason. Fear of government. I'm all in, and have been for years with very good outperformance, based on the hope of coming government reforms. That may be changing.

The pushback from the American people over the past 5-6 years was striking...and resulted in adding reform-minded PUBs to Congress in each of the last 3 elections. This drove up stock markets, because the DEM spending and policies of 2007, 2008, and 2009 were unsustainable. Paul Ryan and other big government politicians are now fighting this pushback and these reforms tooth and nail, and are now winning for the first time. That December bill means it's suddenly getting harder to maintain confidence in our government policies improving. Recent cooperation and compromise with bad policies is a discouraging and troubling development for growth.

The past few years have delivered the best returns and outperformance of my career. It's all come from betting on hope of reform and pushback. If the Fed can allow money markets and T-Bills to begin paying an interest rate, successful investors can finally feel better about booking our massive stock profits, and hiding out in cash as the hope of government reform begins to evaporate. Maybe the folks who have been sitting on the sidelines all these years will step up and start buying my stocks now, so I can step aside. They are cheap!! Once rates rise, and the Hillary/Ryan team crushes growth prospects further, even bonds could look attractive again in a year or so.

If these politicians do crush the hope of reform, it will take another long cycle to bring it back again. Established politicians have now decided who butters their bread. There are more takers than makers, and they know that. None of those takers nor the new illegal voters are clammoring for reform. Voter demographics are beginning to smother reforms. Who is coming to save us, now?? We may be entering a new phase of Fundamental Transformation. We will just have to see.

Interesting as ever Scott. I wonder what you think of Neil Woodford's blog post today (https://woodfordfunds.com/ornithology-monetary-policy/#comment-6700). He is considered the Warren Buffet of the UK fund management industry. Two key quotes from his post today:

1. "Central bankers across the developed economies still seem to look at the post-financial-crisis world through an old world lens, reluctant to admit that the new world is very different. How else can one explain the confidence that the MPC places on the gravitational pull on inflation back to 2% in 2 years’ time?

In my view, it is more likely that we will see further negative inflation in the UK within the next 2 years, than a +2% rate. In essence, I am much more concerned about the threat of deflation than inflation."

2. "There is more risk in markets now than at any stage in the last 5 years."

Rob: As you know from my posts, I am not in the deflation camp at all. In fact, the more people there are that worry about deflation and/or are convinced that inflation will never go up, the more I worry that inflation will go up. Expectations are universally against the idea of inflation rising, and the vast majority of commenters disagree only on how low inflation will go. My contrarian instincts are warming up.

I would in a sense agree that markets are riskier now than at any time in the past 5 years, but only because valuations that 5 years ago were extremely cheap are now much closer to "reasonable." So the cushion against downside risk is smaller now than it has been.

Many thanks Scott, just one more thing: Woodford has commented before that he sees China as the main anti-inflation driver, just as Argentina was at the start of the 20th century - which is to say, a new market opens up to the world, offering a vast supply of very cheap goods .. and just as Argentina prevented inflation in Europe then, so China will prevent inflation in the West today .. the world got bigger then and has got bigger now, so home-grown inflation, whether US or Europe, is over-ridden by other factors.

Rob: I'd prefer to say that monetary policy is what kept inflation low, even as cheap Argentine and Chinese exports flooded the world. Inflation is, after, all a monetary phenomenon. China and Argentina were all about an expansion of global productivity: making more with fewer inputs. They helped the entire world to enjoy a higher standard of living.

In any event, the biggest drop in U.S. inflation occurred from 1981 to 1995 (CPI fell from a high of almost 15% to 3%—since then it has been averaging about 2%), and that was entirely due to the Fed and other central banks' efforts. And that was well before China became a player in the global marketplace (starting in 1995).

I have no background in economics education and what I know is mostly from blogs like yours, so pardon if these are silly questions:

1. "the energy-producing sector of the economy has suffered significantly, and the shock has had a dampening effect on the larger economy. "

Could you elaborate how you got to this conclusion? (that is, household spending less than expected as percentage of revenue is due to the shock from the energy sector. That's how I read it anyhow.)

2. "Inflation is, after, all a monetary phenomenon"Could you please explain this? Lets say in a specific market the amount of money in circulation remains the same under the following scenario: an apple costs 1 USD. Then everyone wants to eat apples instead of anything else. Unfortunately in this market, it is not possible to increase supply for various reasons at this time, for the next 10 years. The apple's price triples. Is the apple price inflationary under your definition?

In a different scenario, the apples supply remains the same, demand remains the same because people don't want to eat more apples, but the money in circulation doubles, and so the price of apples increases. Is the apple price inflationary under your definition?

Or, another country has flooded our little markets with apples and sells them for 0.1 USD. Apple eaters are happy. Apple growers are not.Money supply remains the same. Is this deflationary by itself? Or because the money in circulation was not reduced, it is the local market powers' that default? As it happens, bananas prices have doubled, so if the supply of money was reduced, that would make bananas even more expensive. So, what is the correct monetary policy?

For me, the hard question is "what to buy" in 2016. Stocks? Bonds? Real estate? Precious metals? I personally am strongly committed to owning dividend and rent-earning equities, and I have no regrets with that course given the upward direction of rents and dividends in 2015. However, I am now adding gold and silver positions to my portfolio given the moderately low prices for gold and silver, as well as the prospect for even lower prices going into 2016. My plan is to value-invest into precious metals using excess rents and dividends until I reach 5% of my total portfolio. I am no longer reinvesting dividends into new stocks given that most companies have exhausted their reserves in share buybacks, and I am hesitant about new real estate purchases as interest rates increase. As always, I urge young people to invest heavily into world-class skills that convert into premium wages that can be converted into dividend and rent-earning equities over a lifetime.

I am 2/3 cash and hope the market goes a little higher in early 2016 so I can raise more cash. My sense is that there has been - and still is - much too much complacency in the market. And as Stan Druckenmiller has pointed out, there is as much or more market speculation than before the peaks in 2000 or 2007. When there is an investment "bubble", it is very difficult from inside the bubble for most folks to see the speculation.

Even on this blog - those who post - are writing of buying high yield bonds, high yield stocks, etc. I am the only person writing of selling anything. I can still recall the bearish comments on this blog from 2009 - 2011. Presently, we are a long way from a good buying opportunity. When that time arrives, the comments on this blog won't be about buying anything.

William, good luck trying to time the stock market. In over thirty years in the trading business I have NEVER met anyone who has beaten the market by "timing" it consistently. That said, you may very well be correct but if you are you'll have to be correct TWICE-repeatedly. And that's the reason it is an exercise in futility and why I choose to trade HY bonds which have a built "cheat" which very few are aware of and I'm not about to educate them on.

With 45 years experience I have done just fine, Steve, - and without brokers help, thank you. I don't time the market as you have seen from my posts, I risk adjust. I began to sell in April 2013 from an equity position of 124% long. With present global economic conditions, US slowing profits and present valuations, in my opinion, I shouldn't be more than 36% in equities.

Baron Nathan Rothschild ~ "I never buy at the bottom and I always sell too soon."

If you follow investment professionals, you would know that several storied investors have taken considerable profits and sold down their equity positions including hedge funds managers David Tepper and Stan Druckenmiller. Other investors I follow, Grantham Mayo van Otterloo (GMO), Train Babcock Advisers and Franklin Street Partners have also sold heavily.

You also can follow investors holdings at this SEC website:http://www.sec.gov/edgar.shtml#.VDX3mPlZ1sc

Last May, I being 50% in cash, I wrote on this blog that perhaps "Cash would be King".

Here are the major returns for 2015:

Barclay's Global Treasury GDP Weighted down - 4.65%

Barclay's Global Aggregate Corporate Bonds down - 3.56%

Barclay's U.S. Corporate High Yield down - 4.47%

MSCI All-Country World Index down - 5.4%

Bloomberg Commodity Index down - 26%

Spot Gold down - 9%

I don't have a crystal ball; nor does anyone else. So we shall see. That is the beauty of it.

Happy New Year to Scott, and All of You Blog Posters. It's been fun ;~)

Hans---the word is, more deflation in potash in 2016, and several other commodities, including copper. Some say two more soft years on oil. Even wood markets soft.

Interesting outlook. It may be we are missing the obvious: no economy yet has escaped zero bound. The central banks lack the nerve to print enough money to start real growth, and then persist on that path long enough to bring about moderate inflation.

But we are in a world of capital gluts. Perhaps we should consider there will be chronic oversupply of everything.

I have mentioned some skepticism regarding the Fed's ability to increase the FFR significantly over the past 6 months. On Thursday, the Fed Funds Rate finished the day at .20, falling 5bps below the lower end of the corridor set by the Fed. (https://apps.newyorkfed.org/markets/autorates/fed%20funds#Chart12) Let's get that rate up another 1% with 4 hikes next year!

The ON RRP utilization rate is also far too low at this point at approx. $270B. Waiting to see that ON RRP utilization rate go up about 800% and see what that does to overnight financing in the international markets.

Re: Fed funds rate. I note that today (Jan 4) it is trading at 35 bps, which is 10 bps above the lower end of the corridor. If anything looks unusual, it's 3-mo T-bill rates, which now trade at 0.16%, down from their Dec. 8th high of 0.27%. My guess is that China-related fears are creating strong demand for safe assets. 3-mo Libor today stands at 0.61%, which is very much in line with the Fed's new IOER target.

Things can always get a little crazy around year-end and quarter-end. As for the ON RRP utilization rate, it's still very early and we're still in uncharted waters. Give this some time to mature. Meanwhile, I don't see any serious dislocations in financial markets. I think this is just another case of nerves. Gold is $1075, up only $14 today.

Sometimes it is interesting to see how private money-managers offshore see the U.S.

The Institute for Supply Management (ISM) said its (Dec.) index of national factory activity fell to 48.2 from 48.6 the month before.

One response:

"It was quite unusual for the Fed to raise rates when the ISM is below 50, (which indicates contraction). And we are likely to see another month of contraction. We have to see how long this will continue," said Masahiro Ichikawa, senior strategist at Sumitomo Mitsui Asset Management.

---30---

In other ISM news, "The employment index fell to 48.1 from 51.3 a month earlier. Expectations called for a reading of 50. New orders climbed to 49.2 from 48.9. The prices paid index fell to 33.5 from 35.5, compared to expectations of 35.0."

So deflation, and falling employment, but some good news on the new orders--though still indicating a shrinking economy. This is not what I call a signal for tighter money from the Fed.

I wonder if what Kevin Erdmann said is true: "The Fed can raise rates, the way a kangaroo can fly."

I do not know all the ins and outs of how the BLS measures new vehicle prices. I assume they are controlling for quality.

https://research.stlouisfed.org/fred2/series/CUUR0000SETA01

I concur that measuring many goods and services, over a 20-year period, may result in inaccuracies, or judgment calls. More on that later.

However, compare the dead auto prices to house prices in the last 20 years

https://research.stlouisfed.org/fred2/series/USSTHPI

Eyeballing the chart, it looks like an 80% increase in house prices in the same time frame.

Automobiles are wonderful machines, incredibly complex, parts and raw materials sourced globally, and then shipped globally. Not small either, like iPhones.

Houses are two x fours, put in some conduit for electricity, drywall, plumbing, and you are good to go. Compared to a car, a house is simple. I have built a house, and repaired parts of others.

The takeaway is that what the Fed is fighting is not inflation caused by excess demand. Rather the Fed is fighting artificial housing scarcity caused by ubiquitous property zoning. NIMBY! NIMBY! NIMBY!

But to bring housing into the low inflation zone, the Fed will have to suffocate the rest of the economy.

On inflation: Measuring inflation is a subjective art. Many contend our measures overstate inflation. Maybe so. My takeaway is that the rate of inflation is not very important, as long as it it is under 4-5% or so. BTW, Reagan and Volcker declared victory on inflation when they got it down that low.